Credit Ratings and Firm Innovation: Evidence from Sovereign Downgrades

By exploiting sovereign downgrades as an exogenous shock to corporate credit ratings, this study investigates how credit ratings affect firm innovation. We find that a sovereign downgrade leads to significant reductions in innovation input (i.e., R&D expenditures) and output (i.e., patent applications and citations) in bound firms that have a rating equal to or above the sovereign rating before the downgrade. Further tests show that the effect is concentrated in firms under greater pressure to reduce earnings volatility and firms with higher external finance dependence and that our findings are not driven by economic shocks. Also, we identify the shift in debt choice towards bank loans and the increase in creditor control facilitated by greater use of covenants in loan agreements as potential channels of the causal relation. Since innovation is an important catalyst for economic growth, this study sheds light on the real effects of credit ratings on economic development.